ARE financial markets useful indicators of how an economy is about to perform? If they are, then they are not telling an upbeat story. This year equity markets are flat-to-lower, government-bond markets are up and, as for commodities, the “wrong” raw materials are fallingin price.Economists have adopted some financial variables for their soothsaying efforts.In America, for example, the composite leadingindicator uses, among other things, the change in the S&P 500 index and the spread between short- and long-term interest rates.The theoretical link between markets and economies runs like this.When an economy expands, spare capacity starts to shrink. This puts upward pressure on wages and prices of raw materials as companies compete for resources. As inflation picks up, bond yields rise and the spread between short- and long-term rates widens. Profits rise rapidly in the first stages of recovery; the corporate sector has a high level of fixed costs, and increased demand usually leads to improved margins.The influences on the markets change when the economy starts to overheat. The central bank gets nervous about inflation and raisesinterest rates. Companies suffer from lower margins as their costs rise faster than their revenues. Equity markets run out of steam. If the slowdown looks like turning into a recession, then equities and commodities fall. Government-bond markets, by contrast, gain (and yields fall) for tworeasons: first, inflation is lower in a recession and, second, government bonds are perceived to be safe assets.Given this picture, the record of the financial markets in 2013 looked pretty positive for developed economies as they headed into this year. Equity markets in the rich world did well in 2013 and government-bond yields rose. Admittedly commodity prices fell in 2013, but that was good news for Western consumers: the effect was the same as a tax cut. The picture was far less positive for those parts of the emerging world which produce commodities; indeed, emerging-economy equity markets were generally weak last year.That weakness has continued into 2014. Several developing countries have been forced to tighten monetary policy in the face of wide current-account deficits and falling currencies. Even in the developed world, data have been disappointing: Citibank’s economic-surprise index, which compares published data with the forecast numbers, has shown its biggest decline in a year. Industrial-metals prices, usually sensitive to the state of the global economy, have been dropping. More generally, inflation is low and deflation in the euro zone seems not too far away.Special circumstances may explain some of this. Severe winter weather has affected America’s economy. Falling prices for metals may be the result of a crackdown on speculation in China, where copper was used as collateral for financial transactions. Metals have been weaker than other commodities, although this divergence is not necessarily good news: higher food and gas pricessqueeze consumers’ wallets.Most economists think that America will recover strongly in the second quarter, and that the Chinese slowdown will be modest. That may help explain why rich-world equity markets have not taken a bigger hit, despite the geopolitical worries over Ukraine. If the economy was really heading over the cliff, equity markets would surely have fallen more.The importance of monetary policy should not be underestimated. It is not just that low interest rates tempt investors to move money out of cash and into equities. Low rates also appear to enhance the fundamental attraction of equities.It is a neat trick.Barclays Capital calculates that companies have taken on more leverage: the ratio of their debt to earnings, before interest, depreciation and tax, has increased. This debt is used to buy back shares.InAmerica buy-backs are running at an annual rate of $400 billion, or 2.3% of GDP, according to Smithers & Co, a consultancy.Higher profits are then divided among fewer shares. The effect boosts earnings per share for the S&P 500 index by around2%, reckons Barclays. And another familiar theme of bull markets has started to appear: takeovers. The combination of cheap borrowingcosts and high share prices is ideal for merger mania, boosting the buying power of acquisitive chief executives.All this suggests that, until the central banks start to tighten monetary policy, equity markets will be supported. High share prices are an indicator of confidence in Janet Yellen and Mario Draghi, more than in the economy itself.

Putin takes Crimea, China devalues and Yellen has a shaky debut. Last week I posited that “Ukraine and China pose clear and present dangers to global financial markets.” At least for the week, Russian troops stayed put on their side of the Russia/Ukraine border. And while the West ratcheted up sanctions against Russia, at this point leaders on both sides of this crisis appear keen to avoid actions with real economic impact. At the same time, Putin’s chilling speech Monday supported my view of a darkening geopolitical backdrop – a potential inflection point of historical significance. So let’s direct some attention to China. The Chinese renminbi declined 1.22% this week, boosting its one-month drop to 2.16%. A Thursday Bloomberg headline read “China’s Yuan Slumps Most Since 2008 as Central Bank Cuts Fixing.” My “headline”: Beggar thy neighbor? Ramifications and consequences – financial, economic, geopolitical? After trading near multi-year lows on Thursday, Friday saw Chinese stocks spring to life with a 2.7%surge. The bullish take is that more aggressive fiscal stimulus is in the offing, while the People’s Bank of China (PBOC) is in the process of weakening the currency and is about to ease monetary policy. The increasingly confident bearish view holds that Chinese policymakers are more worried by what appears an acceleration of financial instability and economic weakness. I am reminded that the S&P500 shot to a record high in late-2007, even as the mortgage finance Bubble faltered. The “VIX” (equities volatility/risk) index even traded at a remarkably low20 in early September 2008, as seemingly fearless markets headedright into October’s near collapse. Clearly, markets, financial systems and economies turn highly unstable late in the “terminal phase” of Bubble excess, especially when activist policymakers begin responding to faltering Bubbles and attendant economic vulnerability. This can work for a while to feed the segments of the Bubblestill demonstrating inflationary biases. To be sure, this dynamic is integral to the heightened systemic risks associated with financial imbalances and unbalanced economies.From my perspective, all key indicators point to the beginning of the end to China’s historic Credit and economic Bubbles. Although it appears controllableat the moment (recall subprime?), keep in mind the crisis is in the earliest phase. There was another significant default this week (real estate developer), while corporate bond spreads widenedfurther (see “China Bubble Watch”). Finance has tightened markedly, especially for real estate developers and players along the supply chain. Over time, this will more meaningfully impactlocal government finance that has grown highly dependent upon real estate transactions. Data this week suggest Chinese home price inflation has slowed markedly in most major markets. This supports the view of an important change in market psychology, although this type of thing usually plays out overmonths. Nervous lenders and waning availability of mortgage Credit would speed the process. Importantly, the vast majority of markets still show strong year-on-year price gains and there isn’t much yet to suggest that homebuyers are losing access to Credit. The same cannot be said for the weaker developers. The unfolding crisis in China will turn significantly more problematic as home prices and transaction volumes fall in tandem. This will likely usher in a problematic decline in overall system Credit growth, with waning Credit and liquidity exposing myriad problems. For now, there are indications of mounting apartment inventories. Meanwhile, building additional housing units (apartments) remains an important component of Chinese stimulus programs. The pesky “law diminishing marginal returns” lurks throughout Chinese stimulus and Credit more generally.In the near-term, there are the unknown consequences related to the PBOC’s decision to devalue the yuan. Asian currencies in general were under further pressure this week. The currency devaluation issue will also evolve over weeks and months. Whether there are geopolitical factors at play in China’s move is unclear. And while it has been only a 2% devaluation (versus the dollar) thus far, enormous amounts of “hot money” had flooded into China in anticipation of ongoing currency appreciation. Potential dislocations related to a reversal of speculative flows now create significant uncertainty. This uncertainty is compounded by what are believed to be large speculative flows associated with commodity financing deals. Copper, iron ore and other industrial commodities prices have recently been under significant pressure. Between bad debts, defaults, sinking commodity prices and an unexpected weaker currency, there’s some real pain being inflicted. But where?Since 2008, Chinese international reserves have grown $2.293 TN, or 150% - from $1.528 TN to end December 2013 at $3.821 TN. Over a similar period, Federal Reserve Credit inflated$3.135 TN, or almost370%, to $4.0 TN. For the pastfive years I’ve argued that the Fed’s balance sheet and Chinese Credit are closely interrelated facets of the “global government finance Bubble.” And these days both the Federal Reserve and People’s Bank of China are in the process of major policy adjustments. The “bulls” are generally dismissive of policy changes having much economic and market relevance. From a global Credit Bubble perspective, I don’t think one can overstate the importance of unfolding monetary developments in Beijing and Washington. In the four monthsSeptember through December, Chinese international reserve holdingsjumped almost $270bn. This rise in reserves (largely Treasuries, bunds, sovereign debt, etc.) appeared related to a surge of “hot money” inflows to China. Chinese officials had last year responded to record Credit growth with measures meant to tighten financial conditions. Meanwhile, resulting higher Chinese market yields only strengthened the allure of an already powerful liquidity magnet (operating in over-liquefied and highly speculative global markets). The “hot money” surge complicated the PBOC’s efforts to “lean against the wind” of lending and speculative excess. This torrent of foreign-sourced “money” required the PBOC to further inflate domestic Credit and, in the process, exacerbated financial and economic risks. It also required “recycling” the incoming dollar (along with other foreign currencies) balances back into Treasuries and other debt instruments. Surely, at $3.8 TN, Chinese authorities might today question the wisdom of accumulating more IOUs from the U.S. and others. A change in currency policy might serve Chinese interests on multiple fronts.Meanwhile, chair Yellen’s first FOMC meeting and press conference didn’t go off without a hitch.The bond market was walloped. Ten-yearbond yields jumped10 bpsWednesday to 2.77%. More significantly, shorter maturities surged higher as the yield curveflattened. Wednesday’s action sawfive-yearTreasury yields jump 16 bps to 1.71%, the high since early-January. Three-yearyields increased 13 bps, with yieldsending the week at 0.90%, near the highest level since last August. Those crowded into the perceived safety of short-maturities were kicked in the teeth. I would be curious to know the degree of leverage that has built up in short-term instruments and myriad yields curve trades. Wednesday was one of those intriguing days in the markets. As Treasury yields shot higher, the U.S. dollar rallied and EM currencies fell under immediate pressure. It was reminiscent of the “May/June Dynamic” from 2013. Last year’s so-called “taper tantrum” revolved around mounting market fears that waning Fed-induced global liquidity and attendant risk aversion might exacerbate EM outflows. This would not only further pressure EM currencies, bonds, financial systems and economies, but might also force EM central banks to liquidate Treasuries (and other reserves) as they were forced to employ reserves in an effort to stabilize faltering currencies. There was potential for contagion and a “non-virtuous” cycle.Last year’s “May/June Dynamic” saw Treasury yields surging higher simultaneous with sinking prices in equities, commodities and throughout EM. Many leveraged “risk parity” strategies abruptly faced highly correlated losses across what were supposed to be well-diversified and risk-protected strategies. A continuation of this market dynamic would have tested a key perception of these strategies: superior risk management complimented by leverage. Meanwhile (last spring), the enormous and still ballooning ETF (exchange-traded fund) complexfaced a major reversal of flows in some EM and fixed income products. Rapidly growing funds had been providing strong market support. Suddenly, they turned sellers in what in some cases were less-than-liquid underlying securities markets (i.e. muni and EM debt). A continuation of this market dynamic would have tested one of the key perceptions of the ETF marketplace: superior liquidity. Last year’s “May/June Dynamic” was a critical juncture for what had evolved into highly speculative markets. Key bullish perceptions were in the process of being tested. On the positive side, some excesses were finally beginning to be wrung out of an exuberant marketplace. Yet there was going to be some inevitable market pain and negative economic consequences both domestically and globally. And it was going to come at an inopportune time – as they tend to do. First it was New York Fed president Dudley. Other Fed dovesquickly lined up. And then “Bernanke’s Comment” explicitly stated the Fed was prepared to “push back” against a “tightening of financial conditions”. The Fed would even contemplate boosting QE instead of tapering. The markets got the message loud and clear: The Fed was right there willing and able to support the markets in the event of any trouble. Instead of bullish misperceptions coming to the fore – or mounting excessbeginning to be wrung out – it was the polar opposite: the bulls and speculators were further emboldened by the notion that the Federal Reserve was backstopping the markets and eliminating downside risk. Last week I discussed “tail risk” and the type of backdrop conducive to market dislocations.Aremarkets at risk of another “May/June Dynamic”? A 2014 variety - April/May/June Dynamic? One the one hand, markets would appear to confront similar issues – the potential for higher market yields, EM vulnerability, waning Fed liquidity, etc. On the other hand, complacencystill abounds after the Fed ensured the markets more than persevered through last year’s bout of tumult.Chinese defaults and acute financial fragility weren’t issues a yearago. Confidence in Chinese finance and economic fundamentals was much stronger. Geopolitical risks were much lower. And, importantly, the market was clear on China’s policy of steady currency appreciation versus the dollar. This year’s “April/May/June Dynamic” could easily incorporate a major Chinese component. Chinese reserve holdings declined only slightly last May and June, before “hot money” flows returned with a vengeance by late summer. The prospect of China selling Treasuries was not a market concern.Everything is just so much bigger than before: The Fed’s balance sheet; PBOC international reserves and the Chinese Credit system; the leveraged speculating community; the big “macro” hedge funds; the powerful “quant” funds; the sovereign wealth funds; the ETF complex; the big mutual fund companies.As history has shown, epic financial Bubbles by their nature spur a concentration of financial power. I often ponder how a marketplace dominated by big players tends to function differently than traditional decentralized marketplaces. Then I contemplate how such a “centralized” marketplace operates with assurances of ongoing central bank support. In my mind – and I see evidence for as much in the marketplace – the markets become more of a game, more speculative and increasingly detached from fundamental prospects.Janet Yellen has a really tough job ahead of her.The markets Wednesday got a glimpse of why she was not the Administration’s first choice. As the bond market was getting hammered, she was rambling on about the minutia of labor statistics. In a period of what I expect to be only rising market uncertainties (particularly Fed policy, China, EM and geopolitical), I fear our new Fedchair will not inspire confidence.Yet only time will tell if I end up at some point titling a CBB “Yellen’s Comment.”How will she – how will the Fed – respond to a bout of destabilizing market de-risking/de-leveraging? Interestingly, Dallas Fed head Fisher stated Friday that the “Fed had taken a great deal of volatility out of the market” and that “some more market volatility would be healthy.” For the bond market, it appeared participants this week were finally forced to face up to the reality of a more hawkish bent at the FOMC. There is an increasingly assertive contingent that wants to move beyond Bernanke inflationism and get back to more traditional central banking. That would mean winding down balance sheet expansion as soon as practical and then preparing to lift rates off the “zerobound.” And all of this really begs the question: to what degree can the Federal Reserve’s balance sheet be counted on as the markets’ future liquidity backstop? Actually, whether the Fed builds its holdings (“prints money”) or notis of seemingly little concern to the markets - that is so long as the markets remain buoyant (as they’ve been). Yet an eruption of de-risking/de-leveraging would have this backstop issue quickly elevated to the top of market worries. Moreover, this liquidity issue would be significantly compounded if the change in China’s currency policy incites a reversal of “hot money” flows and, perhaps, a resulting turnabout in China’s international reserve holdings.

All the major US banks passed the tests, which modelleda hypothetical recession and market meltdown to gauge the resilience of the financial system. Of 30 banks tested, only Zions, a Utah-based lender, failed to maintain a minimum capital ratio of 5 per centequity to risk-weighted assets.

But BofA, Morgan Stanley, JPMorgan and Goldman all came out with less than a 7 per cent capital ratio – much weaker than anticipated.In the crisis scenario, BofA would make a $49.1bnloss, the worst performance of any of the banks and its capital ratio would plummet to 6 per centbefore any share buybacks or higher dividends.

The tests were used as the basis for the Fed’s assessment of banks’ capital return plans, which will be released on Wednesday.

Any bank whose dividend and buyback plans would cause it to burn through the 5 per cent capital threshold could suffer an embarrassing veto by the Fed and have to resubmit a lower request.

Those requests are private until next week. However, there are clues on whether those weaker performers risk a Fed veto, which in previous years has dealt blows to the credibility of BofA and Citigroup.

Analysts warned that on more than one measure of capital, BofA was close to the limit. “It’s narrowerthan you’d like,” said Glenn Schorr, analyst at ISI Group in New York, adding that BofA should still have excess capital to allow for its share buyback and dividend plans. JPMorgan’s stressed ratio of 6.3 per centequates to about$17bnabove the 5 per cent minimum. The bank has signalled that it intends to ask permission for a capital return of less than $10bn and therefore should pass – though the Fed can still fail an institution if examiners findother weaknesses in its capital planning.The overall picture in the fourth round of stress tests since 2009 showed the US financial system with much more loss absorbent capital than it had five yearsago, making it better able to withstand a severe shock.The Fed found that the largest US banks would lose a total of $501bnunder the crisis scenario – which included a severe recession with an unemployment rate of more than11 per cent.Given the settlements and fines that banks have paid to resolve allegations of wrongdoing, the Fed asked banks to pay particular attention to litigation exposure for this year’s test, central bank officials said. Operational risk losses were about45 per centhigher this year, largely because of litigation expenses.One of the differences in this year’s test was that the Fed used its own calculations for balance sheets and risk-weighted assets.That meant, while banks assumed a smaller balance sheet in a crisissituation, the Fed projected a small increase in their balance sheets. Fed officials said the bar would continue to rise over the next several years.The aggregate tier one common capital ratio, which compares high-quality capital to assets measured on a risk basis, would drop to a minimum of 7.6 per cent in a crisis situation, compared with the 11.5 per centrecorded by the banks in the third quarter of 2013.Overall, the total amount of tier one common capital held by the 30banks subject to the tests fell more than$396bn, or about41 per cent.State Street, Discover Financial Services and Bank of New York Mellon emerged as the strongest banks in a crisis when it came to tier one capital ratios, with all of them having a minimum of at least 13 per cent.Wells Fargo improved its capital ratio to 8.2 per cent, the strongest of the sixbiggest US banks.“The tests should be thought of as less of a supervisory tool and more of a way to say whoshould and should not be allowed to distribute capital,” said Moshe Orenbuch at Credit Suisse in New York.

Bank holding company

Stressed Ratios “Tier one common” capital as a percentage of risk-weighted assets

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.